In our last newsletter we wrote about the different investment strategies PE firms are currently pursuing. While PE activity in banking seems to increase and broaden almost weekly, these activities appear to fall into four areas:

* Line of business investments. In this instance the PE group focuses on buying specific “non-core” businesses from a bank, typically with the call of creating a larger entity or roll-up of units from multiple banks. Businesses that these firms appear to be considering include brokerage and indirect auto, among others. Activity in this area is limited as a significant gap exists between the bank and investor’s view of the asset’s value

 

* Minority investments in distressed or underperforming banks. The emphasis here is on the PE firm buttressing bank capital by adding capital or capital-like debt and taking a minority position in the bank. As with the above area, this has also been a slow growth area in part because of the reality gap that currently exists between banks and PEs. In short, pricing of the investment is where these deals often hit a snag as the two parties place different valuations on the bank’s current and future performance.

 

While all of these areas are still developing, this one seems to require a more informal approach, whereby a wealthy investor (in several cases a former bank CEO) invests both dollars and time. However, this could be a major area of activity if commercial real estate lending (CRE) delinquencies and losses continue to increase (to be discussed below).

 

* Majority investments in distressed banks. This is the area that has received the most mention recently with both the IndyMac and BankUnited deals receiving much publicity. As has been discussed in the press, this type of deal requires a loss-share agreement with the FDIC, whereby the government and investors share in both loan losses and recoveries.

 

Given that the FDIC now has more than 300 names on its troubled bank list, this is a major growth area for PEs. In addition, PEs appear to have cracked the code concerning how they can, in effect, achieve control without becoming a bank holding company. The solution is for PEs to team up together (an investing model they use in other industries) to ensure that no one buyer owns more than 24.9% of the bank, even though the group together owns 100%.

 

This is the likely model for many more deals going forward: PEs hold the investment dollars required; the government is becoming more comfortable working with them; this structure allows for management change. This last factor is critical to increase the likelihood that the government and investors will receive a positive return. Almost every PE firm we know has lined up experienced bankers to parachute into expected investment situations. However, not all senior bankers are alike; PEs need to be concerned that they have selected the right type of manager rather than a “name.” Required are leaders and businessmen, not managers and bureaucrats; they need to roll up the sleeves and work with laser-like focus on the critical issues for success while establishing a vision for the future.

 

By the way, one deal in which one outside investor rather than a group received OTS approval for majority ownership is Matlin Patterson’s investment in Flagstar Bancorp of Troy, Michigan. Over coming months, regulatory changes may mean this type of structure is no longer acceptable; that is TBD.

 

* Majority investments in “healthy” banks. Some investors believe that starting with a healthy bank is preferable to working through the challenges of a distressed situation. Within that group, a subset are willing to operate as bank holding companies in order to have full control. Fortress Investments just led an investor group in investing $800 million in First Southern bank, a Florida bank that the Financial Times describes as “having a relatively clean balance sheet.” The structure of the deal shares ownership to avoid exceeding 24.9% ownership. Conversely, other groups, most notably Belvedere Capital, may take greater ownership and operate under the bank holding company act.

 

This is the area where many analysts expect significant growth. However, we think the hangover that has yet to be addressed by the industry will increase opportunities for investors focused on distressed situations.

 

The Commercial Real Estate Meltdown?
Many recent articles about the banking industry point to the payback of TARP funds and the ease of raising common stock as two indications of the return to health of the banking industry. Unfortunately, we are not too sure about that. Last week, SNL published an article that showed how the delinquency rate for CRE loans jumped 140 basis points in the first quarter versus a 93 basis point increase for one- to four-family real estate loans. The article states that the delinquency problem is particularly pronounced in banks with less than $10 billion in assets.

 

The tie-in between CRE and PE is that the pool of weaker banks that will need capital and/or government intervention may be increasing over the next six months. “Distressed” deals, particularly those that require government intervention, are likely on the rise.
 
Concluding Thought
Private Equity’s role in the banking industry is still in its infancy, with the type and extent of its involvement to be determined during the course of 2009 and 2010. PE firms may be investors in hundreds of banks over the next two years. With their dollars, they bring discipline, focus, energy, and expectations that far exceed those of many bankers today. The industry will be better off for the involvement of PE firms. Appropriately, the Financial Times quotes one commentator on the BankUnited and First Southern deals: “Regulators now have two well-capitalized banks to help them deal with other troubled banks in Florida.”